I have more than 35 years’ experience as an attorney and financial planner, and I’ve worked with hundreds of business owners to solve problems, exit their businesses or retain their top talent. I work all over the country with financial advisors and business owners themselves to help them better prepare for their financial future. My blog is focused on financial intelligence for business owners. I'll talk about current events, experiences I've had with business owners, and a lot about taxes.
Steve is a National Advanced Solutions Director with the Principal Financial Group®, Des Moines, IA 50392. While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that the author is not rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
*JD is an educational degree and the holder does not provide legal services on behalf of the companies of the Principal Financial Group.
*Insurance products from the Principal Financial Group® are issued by Principal National Life Insurance Co. (except in NY) and Principal Life Insurance Co., Des Moines, IA. Securities offered through Princor Financial Services Corp, Member SIPC (www.SIPC.org), Des Moines, IA. 50392

Small Business Owners And Taxable Income -- Setting The Record Straight

The small business owner was iconic during this last election cycle. The rage all started four years ago with Joe the Plumber, and the candidates in this last run have since elevated the small business owner to near sainthood. With this lofty status, however, have come the inevitable detractors. I’ve heard a number of critical comments thrown around about the financial status of business owners: they don’t pay taxes because they deduct everything; they think making $250,000 is just keeping them in the middle class; citing Buffet and Romney, they assume all business owners pay less than a 20% top income tax bracket.

Let’s set the record straight. Yes, some small business owners report a lot of taxable income. However, in many cases, these owners actually net less spendable cash flow than their non-equity owning equivalents. In some ways, our tax system makes it more expensive to own a business than to be paid a wage. Consider the tax challenges of the employee/shareholder.

Flow-through Taxes – The overwhelming majority of small businesses are flow-through companies. The profits of the business effectively flow through to the owners of S Corps, partnerships, sole proprietors and most LLCs. Even Professional Corporations essentially act as a flow-through. Although this form of tax helps business owners avoid being subjected to double taxation, it also means the owner pays taxes on everything earned — regardless of whether those earnings are distributed currently or not. An owner of a flow-through entity may show a high taxable income, but not have much actual cash to show for it in any one year. I had an S Corp owner say to me he was “rich on paper, but poor on cash flow.”

Employment Taxes – Employees complain about the hit to the pay check caused by employment taxes: FICA, Medicare, etc. Most don’t realize the employer is usually matching those payments. So, if you own a small business, you are often paying the equivalent of double the amount of employment taxes as what your non-owner employees are paying. This is particularly hard on partnerships and most LLC members who participate in management, because both “guaranteed payments” and the distributive share of partnership income and loss are subject to the double employment tax hit.

Fringe Benefits: The 2% Rule – Without getting into the details, most owners of small businesses are actually subject to reverse discrimination when it comes to taxation of fringe benefits. Consider this. Shareholder/employees owning more than 2% of an S corporation are treated the same as partners for fringe benefit purposes. Generally, such an employee’s medical insurance costs paid by the S corporation are deducted by the corporation and included as compensation in the form of wages to the shareholder/employee. Similarly, if disability income insurance is paid for by the company, the premium is taxable to that employee. The same applies to group term life insurance. Non-owners enjoy the many tax benefits of these bedrock employee benefits, whereas the owners, who are taking the risk with the business, have to report these benefits in their tax returns.

Fringe Benefits: Retirement Plans – For smaller companies, it can be a challenge for the business owners to maximize the advantages of qualified and nonqualified plans. For example, compared with their executive counterparts in larger companies, it may be difficult to get sufficient, regular employee participation in a 401(k) plan to allow the owner to defer the $17,500 maximum contribution limit. Owner-employees are typically the “Highly Compensated Employees” and the various qualified plan tests used to determine deferral percentages can limit what the owner-employee can contribute. Further, while nonqualified deferred compensation is a great tool for spreading out taxes for an executive, flow-through taxation often inhibits the owner of a small business from leveraging this deferral tool. Whatever they defer from their W-2 will show up in their K-1, and they’ve gained no deferral advantage.

These examples are not meant to sing a song of pity for the small business owner. There are clearly tax provisions which incentivize and encourage entrepreneurs to take risks. They are, however, illustrative of why there is so much discussion in Washington D.C. about the taxation of small businesses. Small business owners may show a lot of income for tax purposes, but they don’t always have that income to spend.

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